THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 372

340 PA R T I V The Management of Financial Institutions OF F- BAL AN CE- SHE E T ACT I VI TI E S Although asset and liability management has traditionally been the major concern of banks, in the more competitive environment of recent years banks have been aggressively seeking out profits by engaging in off-balance-sheet activities Offbalance-sheet activities involve trading financial instruments and generating income from fees and loan sales, activities that affect bank profits but not appear on bank balance sheets Indeed, off-balance-sheet activities have been growing in importance for banks: the income from these activities as a percentage of assets has nearly doubled since 1980 Loan Sales One type of off-balance-sheet activity that has grown in importance in recent years involves income generated by loan sales A loan sale, also called a secondary loan participation, involves a contract that sells all or part of the cash stream from a specific loan so that it no longer is an asset on the bank s balance sheet Banks earn profits by selling loans for an amount slightly greater than the amount of the original loan Because the high interest rate on these loans makes them attractive, institutions are willing to buy them even though the higher price means that they earn a slightly lower interest rate than the original interest rate on the loan, usually on the order of 0.15 percentage points Generation of Fee Income Another type of off-balance-sheet activity involves the generation of income from fees that banks receive for providing specialized services to their customers, such as making foreign exchange trades on a customer s behalf, servicing a mortgagebacked security by collecting interest and principal payments and then paying them out, guaranteeing debt securities such as banker s acceptances (by which the bank promises to make interest and principal payments if the party issuing the security cannot), and providing backup lines of credit There are several types of backup lines of credit The most important is the loan commitment, under which for a fee the bank agrees to provide a loan at the customer s request, up to a given dollar amount, over a specified period of time Credit lines are also now available to bank depositors with overdraft privileges these bank customers can write cheques in excess of their deposit balances and, in effect, write themselves a loan Off-balance-sheet activities involving guarantees of securities and backup credit lines increase the risk a bank faces Even though a guaranteed security does not appear on a bank balance sheet, it still exposes the bank to default risk: if the issuer of the security defaults, the bank is left holding the bag and must pay off the security s owner Backup credit lines also expose the bank to risk because the bank may be forced to provide loans when it does not have sufficient liquidity or when the borrower is a very poor credit risk Banks also earn fees by creating financial instruments like the structured investment vehicles (SIVs) mentioned in Chapter and selling them off to investors However, as became clear during the subprime financial crisis of 2007 2008, when they decline in value, many of these financial instruments have to be taken back onto the balance sheet of the bank sponsoring them, because to otherwise would severely damage the reputation of the bank Even though these financial instruments at first appear to be off-balance-sheet, in reality they are back on the balance sheet if they are subject to large losses To their regret, banks ended up taking large losses on these financial instruments during the subprime financial crisis, indicating that these off-balance-sheet vehicles exposed banks to just as much risk as if they had been part of the balance sheet at the outset